AEB 3103 Principles of Food and Resource Economics
Module 6: The Economics of
Taxation
In this world nothing can be said to be certain, except death and
taxes - Benjamin Franklin
What is the first word you think about when you think about tax?
Type of taxes
- Exercise tax: tax on goods and services
- Everything you buy, you pay 6% tax in Florida
- OR and NH has no exercise tax
- Income tax: tax on income
- Different brackets; federal and state income taxes
- Corporate tax
- Capital gain tax
- Tariff
And here’s a couple of statement about taxes. Are they correct?
- Tax only affects those who actually pay taxes.
- For example, taxing Canadian steel = Canada will pay for that
tax.
- Taxing food and beverage = consumers will pay for that tax
- Lower taxes stimulates consumption, which boosts the economy through
multiplier effects.
- Income tax makes people less likely to work.
A simple model on tax
Say the government imposes a tax of $40 on each night of hotel room
stay.
- How does that affect consumption?
- Distortion; tax neutrality
- Who is paying for the tax?
- What are the “spillover” effects?
- The $40 excise tax is shared between buyers and sellers.
- The equilibrium price of hotel rooms falls to $60 a night.
- Hotel guests bear some of the burden as price paid by the guests
(price plus tax) RISES from $80 to $100.
- Hotel owners also bear some of the burden as their price FALLS from
$80 to $60.
- It is not necessarily the case that consumers and producers bear
equal burden of tax
- In fact, it is rare that tax burden is equal
- In a long-distance relationship, for example, who will do more of
the driving?
If demand of some good is more elastic than supply and a tax is
imposed on the consumption of the good, who will bear more of the burden
of the tax?
- producers, because consumers have a greater ability to change their
behavior in response to the tax
- both parties will share the burden equally
- consumers, because they pay the tax out of pocket
- the government, because the tax will cause less of the good to be
produced and consumed
In-class exercise
The demand curve for apple is P = 10 - 2Q. The supply curve for apple
is P = 0.5Q. The government decided to impose a 30% tax on all apples
sold in the supermarket, levied on the consumers. Please calculate:
- The market equilibrium without the apple tax
- The market equilibrium with the apple tax
- Government’s tax revenue
- The share of taxes paid by consumers vs. producers
- The amount of deadweight loss as a result of the tax
Exercise tax creates distortion
- Deadweight loss is higher when
- Demand is more elastic
- Supply is more elastic
- Deadweight loss is lower when
- Both supply and demand are inelastic
If we have to tax consumption, which of the followings should we tax
in order to minimize distortion?
- Gasoline
- Apple
- Apple Computer
- Cigarette
- Salt
- Green House Gas Emission
Two remaining questions
- Do we actually want lower or higher tax rates?
- THE debate between smaller or larger government
- Given a fixed tax revenue target, which taxes should be levied?
1. Lower or higher taxes
Two very different paradigms:
- US: low tax rate, limited public service
- Scandinavians: high tax rate, highly-subsidized public service
Public services in Denmark
- Free healthcare
- Free education
- Heavily subsidized childcare
- 52 combined weeks of parental leave
- 24 weeks for each parent plus 4 weeks for mother before birth
Arguments for/against higher taxes
- Tax evasion: people find ways to evade paying taxes
- Income tax might discourage labor supply
- Tax avoidance: selective taxation creates distortion
- Supply-side economics: cutting taxes stimulates the economy
- But there’s really no free lunch
What should be taxed if we have to tax?
- Tax on regular items is “bad” because it creates distortion
- If you tax one item, people 1) consumes less of it; 2) move to its
substitutes
- Tax neutrality: economic decisions should be made based on economic
merits, not tax reasons
- Other than those decisions that the government wants to
encourage/discourage
- Basic principle of taxation: lower tax rates and broaden tax base
- If you tax everything at the same rate, there is no substitution
effects
In some instances, we may want tax to achieve specific goals - in
those cases, tax is designed to be non-neutral: * Encourage home
ownership * Encourage health insurance adoption * Discourage carbon
emission - Pigovian tax: correcting externality-generated distortion *
Discourage cigarette consumption
- Mortgage interest for up to $750,000 is tax deductable
- If you buy a $750,000 property at today’s rate, your annual interest
payment is here
- Standard deduction is at $25,000 (married file jointly)
- Annual tax savings at 22% marginal rate: $4840 + additional
deductions
- Total cost of the program: $70 billion
What does the mortgage deduction program incentivize?
A note on externality and Pigovian tax
- With the presence of externality, market equilibrium will NOT be
efficient
- The ultimate cause of environmental problems
- AEB 2451 / AEB 3450 specifically deal with this problem
- One of the ways to address it is to use Pigovian taxes
Deadweight loss with externality
Pigovian tax corrects externality